Thin capitalisation – how do you measure up?

521X250KSV 0150
20
Sep

Thin capitalisation – how do you measure up?

20.09.13

In simple terms, the thin capitalisation rules operate so as to deny deductions for interest expenses where an entity’s debt exceeds the maximum allowable level. There are a number of different methods for calculating the maximum debt, the most common being the 'safe harbour debt amount'. The rules also apply differently to inward investors (those controlled by non-residents) and outward investors (Australian entities with offshore investments).

 

For purely Australian domestic entities (that is entities that are neither foreign controlled nor have foreign investments) or which meet certain legislated exceptions (for example, the de minimis exception) the rules have no application.

 

In the Federal Budget, the government announced that it will tighten the thin capitalisation regime further limiting the deductions available for interest (and certain other debt deductions) for income years commencing on or after 1 July 2014. The main change impacting businesses is a reduction in the 'safe harbour' debt limit for general entities from a debt to equity ratio of 3:1 to 1.5:1. This could result in interest deductions of up to 20% being lost.

 

It's not all bad news as an attempt has been made to refocus the thin capitalisation rules, increasing the de-minimus level from $250,000 to $2 million of debt deductions. This de-minimus threshold applies to an entity and all of its associated entities. We have outlined below a simplified example of the potential impact of the proposed reduction in the safe harbour debt limit.

 

 

Current threshold

Proposed  threshold

Assets

$20,000,000

$20,000,000

Non interest bearing liabilities

$5,000,000

$5,000,000

Interest bearing liabilities

$11,250,000

$11,250,000

Net assets

$3,750,000

$3,750,000

 

 

 

Safe harbour amount

$11,250,000

$9,000,000

Excess debt

Nil

$2,250,000

 

While interest rates are currently at low levels, entities may be locked into higher interest funding agreements and therefore not be able to access the de-minimus threshold exception. Given the potential impact of the change in safe harbor threshold, when preparing plans and forecasts for the upcoming years consideration should be given to future debt levels and funding requirements. Entities may need to consider the potential application of the thin capitalisation rules despite previously having 'head room' from a safe harbour debt perspective. 

 

A number of options exist for entities including converting debt to equity; however, some of the options may have tax consequences in Australia and overseas.  Accordingly, caution should be exercised before undertaking such strategies.

 

If you have any questions in relation to thin capitalisation or changes in approach to funding, please contact your relevant ESV engagement partner on 9283 1666.

 

Article by David Prichard